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Cowabunga! Testing the Active ETF Wave

Actively managed ETFs are a fast-growing niche, rife with benefits and challenges

Illustration by Chris Gash

Actively managed exchange-traded funds occupy only a tiny corner of the now-vast ETF world. Though small in number, they have been mighty in grabbing attention. So far, though, actively managed ETFs have not lived up to their hype as financial services’ Big New Thing.

“The space has been long on smoke and short on fire. It’s just a drop in the bucket in the grand scheme of things. Many were expecting the success of PIMCO’s Total Return ETF (BOND) to be the catalyst, but that hasn’t happened. It’s tough to tell what it will take for the space to really take off, if it does at all. But no singular item will move the needle,” says Ben Johnson, director of passive fund research, Morningstar, in Chicago.

Totaling assets of $14,427,770,639, actively managed ETFs represent less than 1% (0.94%) of the big ETF $1,534,310,188,007 market, as of July 31, 2013, according to Morningstar. Of the 1,497 ETFs available, only 321 are actively managed. Further, about two-thirds of actively managed ETF assets are in only one ETF: PIMCO’s BOND.

Providers of actively managed, however, are out there pitching.

They stress that in their first five years, actively managed ETFs—which debuted in 2008—have grown faster in number and assets under management than did index-based ETFs in their initial five years. The first ETF came on the scene in 1993. Actively managed ETFs saw a 78.96% increase in AUM from July 2012 through July 2013.

“Now financial advisors can run a portfolio just like institutional investors do. The process of hiring and firing managers is now as simple as a ticker symbol and a brokerage trade,” says Noah Hamman, CEO of AdvisorShares, an issuer of actively managed ETFs only and based in Bethesda, Md.

Clearly, the key to success in actively managed ETFs lies with the manager. “The fact that a fund is actively managed isn’t a panacea in itself. The manager needs to be skilled and add value, and the approach has to make sense. Advisors need to understand where the advantages are,” says Ryan Issakainen, senior vice president and ETF strategist at First Trust Advisors, headquartered in Wheaton, Ill., offering five actively managed funds of a total 72 ETFs.

It’s no secret that index ETFs increasingly have been taking big bites out of the traditional mutual fund market. It is this space that is most vulnerable to the power of actively managed, providers say.

“If you push away the 401(k) market and the insurance base, there are probably $6 trillion of taxable mutual fund assets out there, of which about 60% are no-load. That,” Hamman says, “is the opportunity in the marketplace for actively managed ETFs.”

Right now, most of the action is in bond funds as opposed to equities. As for the buyers: “People investing in actively managed tend to be small investors, and they’re not very many of them,” says Gary Gastineau, president of ETF Consultants, based in Bonita Springs, Fla., and author of The Exchange-Traded Fund Manual (Wiley Finance, second edition 2010).

So far, the advisors most attracted to actively managed are fee-based versus commission-based, and that trend is expected to continue.

It may be that many FAs shy away from actively managed ETFs because they feel ill-equipped to invest in them. A research study by Cerulli Associates, released in July, shows that FAs are notably hazy on ETF liquidity and how the funds are traded.

Yet, according to a Cogent Research report released this past July, “For the first time ever, advisors say they are as likely to invest new dollars in ETFs as they are to invest in mutual funds.”

Seeking Winners

When it comes to actively managed, Step One is to determine if the asset class under consideration would benefit from the active approach. Certain asset classes have inherent “peculiarities” in indexing that active management might overcome, says Issakainen.

“Determine where there are flaws in the index-based approach and a solution through active management,” Issakainen continues. As an example, he points to the below-investment-grade credit space. Index-based investing weights a portfolio to the largest issues of debt. “That fails the common sense test.”

Step Two is to research managers’ strategies and records of risks and returns.

“You don’t want to own an actively managed ETF just because it’s actively managed,” Issakainen says. “You still have to have a manager with a track record that he’s developed over three to five years.”

“Now, for the first time, advisors can transition more of their clients’ assets into a product that has an alpha-seeking investment objective but with the flexibility and transparency that index-based ETFs have,” Hamman says.

With interest rates rising, risk management has become more important than ever. But “it’s not just interest rate risk but also credit risk and the risk of certain industries and geographies,” Issakainen points out. “An active manager can mitigate those risks. In most instances, with an index-based approach, you don’t have that flexibility.”

Though a number of firms have filed with the SEC for permission to offer actively managed ETFS, few have launched them. Part of the reason is the lengthy approval process. Another side is that “all the actively managed mutual fund companies have filed because they want to be there should they be forced into the ETF space if they’re suddenly unable to compete outside ETFs,” Issakainen says.

Also, “the reason we see so many filings but few actively managed mutual fund companies jumping in with two feet is that, in many cases, if they get into the ETF space, they’re going to have to cut their fees. So some of the larger fund companies hesitate because they can charge more with an open-end-fund chassis as the vehicle that’s delivering their management,” Issakainen says.

In addition, firms are filing to introduce actively managed short-duration fixed-income ETFs as an option to protect them against “unfavorable regulation that may come about pertaining to money market mutual funds,” according to Johnson.

Actively managed ETFs are not—yet—pulling assets away from mutual funds, with the exception of PIMCO, which in 2012 unveiled an actively managed ETF version of its open-end mutual fund, the biggest fund on the market. According to Issakainen, BOND has in fact outperformed its elder brother.

Notes Johnson: “BOND’s success was almost a mathematical inevitability. It was the younger ETF sibling of the world’s largest mutual fund, managed by star manager Bill Gross. So I’m skeptical that most firms can replicate the type of success PIMCO has seen in the actively managed space to date.”

Johnson continues. “But just by changing the distribution mechanism, PIMCO has done investors a great service: The ‘A’ share of the Total Return mutual fund has a [3.75%] front-end load; the ETF can be bought in amounts as low as a single share, and there is no load. Also, the expense ratio on the ETF is nearly half that of the ‘A’ share.”

Joint Approach

There are indeed advantages to the actively managed ETF over both the open-end mutual fund and the index-based ETF. But Hamman recommends using index and actively managed ETFs simultaneously in portfolios.

“You have to keep a balance,” Hamman says. “Advisors would be smart to use index-based strategies right alongside active, or alpha-seeking, strategies. Active managers have a tendency to shine in an area where there is less availability of information: small-cap stocks, for example. A manager really has to kick the tires on a company and do a lot of due diligence. Also, the fixed-income marketplace has no centralized exchange. So you need to do your due diligence on bonds too.”

Hamman even recommends investing in both index-based and actively managed ETFs in the same market sector. “Sometimes indexes are outperforming; sometimes the active managers are shining. Getting your clients exposure to both gives them the best opportunity.”

Looking ahead, actively managed is expected to continue to outpace index ETFs in asset growth and, over time, become more significant.

“A lot of money now in actively managed mutual funds will move into actively managed ETFs—you’ll see a great deal of conversion,” Gastineau says. “Actively managed will surpass index ETFs in [the amount] of assets invested in them.”

Further, Hamman sees opportunities in the large-cap space with a “hybrid” index-based approach using “enhanced” index ETFs, which he defines as “passive index ETFs that track more active indexes.”

Actively managed hasn’t taken the market by storm; nor is it now expected to. Use will be gradual.

Still, Johnson predicts a day when “the ETF is agnostic to what it’s delivering to end investors—exposure to the S&P 500 index or, for example, to Bill Gross’s strategy—and is just a distribution mechanism. That’s the potential upside. Managers using ETFs to deliver their strategy in a lower cost manner to investors has a lot of promise.”

SIDEBAR

Debating Values

Trading actively managed ETFs based on net asset value is the way to go, according to Gary Gastineau, president of ETF Consultants and formerly director of product development at the American Stock Exchange.

Gastineau’s concept for NAV-based trading, in which ETFs are non-transparent, was acquired by Eaton Vance in 2010; and it is the first firm to file with the SEC for permission to offer these “Exchange-Traded Managed Funds,” Gastineau says. He expects ETMFs to be on the market in about a year.

“You have to trade ETFs so that the exact contents of the portfolio is not known and doesn’t create a problem for market makers,” Gastineau notes.

His reasoning: “You have no idea what the value of an index ETF is at the time you’re trading it; so you could be paying a lot more than you realized. With NAV-based trading, you know that you’re buying with some relationship to net asset value, and you can calculate it to the nearest fraction of a penny per share.”

Other ETF experts are skeptical.

Non-transparency is unimportant, says Noah Hamman, CEO of AdvisorShares. “I’ve never seen one research appear that says a non-transparent manager outperforms a transparent manager. I’ve seen no proof that non-transparency provides more alpha.”

When it comes to small-cap stocks, Gastineau contends, “with something that takes longer than a single day to make changes in your portfolio, the cost of transitioning will be very painful—and [with transparent ETFs] you’re showing the world that you’re selling XYZ and buying ABC and will do more of that for the next few days.”

ETF NAV-based trading is philosophically a step backward, in Hamman’s view. “I’m nervous about how efficiently they’ll trade. It feels like non-transparency is far more about the portfolio manager than the investor whose money they’re managing.”

Morningstar’s Ben Johnson, director of passive fund research, isn’t entirely sold on the idea of non-transparency. “It would seem to make an orderly market difficult if market makers can’t have a sense of what’s actually in the underlying portfolio in real time.”

Acknowledging that non-transparent actively managed ETFs could be advantageous with certain asset classes, Ryan Issakainen, senior vice president-ETF strategist at First Trust Advisors, nevertheless, says: “The fact that we have to disclose our holdings in our actively managed funds hasn’t been a detriment. The investing public doesn’t necessarily know what you’re going to do before you do it. They find out after you’ve already done it.”

Gastineau’s enthusiasm is undeterred. He says: Once the ETMF is available, “you’re going to see an awful lot of people lined up to use it.” —JWR